Question 4 (a)
Gordon's dividend model and its shortcomings
7 marks
- Time to write
- About 14 minutes
From an older CBCS paper
Question
Question 4 (a) · 7 marksExplain the dividend model of Gordon. What are its shortcomings? 7
Reworded from the university paper; the task is the same. The original paper belongs to the University of Delhi. See DU's question bank.
Before you write
Read off the question and its marks
Read from the question
- ExplainEach point stated, then explained in a line or two.
Write it in this order
- Read; underline the asks; jot your points 1 min
- 1 The view: relevance and bird in hand 1½ marks 3 min
- 2 Assumptions 1½ marks 3 min
- 3 Formula and implications 2 marks 3 min
- 4 Shortcomings 2 marks 3 min
- Check: every ask answered, key terms underlined 1 min
Short on time? Trim steps 1–4 evenly rather than skip one: each is capped at its own marks.
Try it first. About 14 minutes for 7 marks. Write it out, then open the solution.
Solution
Hover or tap a marked figure, like 72,000, to see how it is made and where else it appears.
The view. Myron Gordon holds that dividend policy affects the value of the share: investors are risk-averse and value current dividends more highly than uncertain future gains, so they discount a firm's earnings at a lower rate when more is paid out ("a bird in hand").
1Sunita holds this year's dividend—money in her hand today.
Current dividendsInvestors put a premium on certain returns.
2Verma ji's payout sits inside a half-built project, and he worries.
Retained earningsUncertain future gains.
3At the counter, savers crowd the company that pays now over the one that promises later.
Bird in handInvestors are risk averse and value current dividends more than uncertain future gains.
- an all-equity firm, with investment financed only by retained earnings;
- the rate of return (r) and the cost of capital (ke) are constant;
- a perpetual life;
- a constant retention ratio (b), so growth g = br is constant;
- ke > br.
The formula. P = E(1 − b) ÷ (ke − br), where P is the share price, E the earnings per share, b the retention ratio, r the rate of return on investment and ke the cost of equity.
- r > ke (growth firm): the price rises as the payout falls.
- r < ke (declining firm): the price rises as the payout rises.
- r = ke (normal firm): the payout does not affect the price.
Shortcomings. The model's assumptions limit it: a firm rarely finances all its investment from retained earnings, ignoring external finance; r and ke do not stay constant as investment grows and risk changes; the retention ratio and growth rate are not constant in practice; and the formula breaks down when ke ≤ br. It also ignores taxes and flotation costs.
Where the 7 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | The view: relevance and bird in hand | 1.5 |
| 2 | Assumptions | 1.5 |
| 3 | Formula and implications | 2 |
| 4 | Shortcomings | 2 |
| Total | 7 |
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